Bubble Meter is a national housing bubble blog dedicated to tracking the continuing decline of the housing bubble throughout the USA. It is a long and slow decline. Housing prices were simply unsustainable. National housing bubble coverage. Please join in the discussion.

Tuesday, November 03, 2009

How the crisis could change economic theory

The crisis exposed the inadequacy of economists' traditional tool kit, forcing them to revisit questions many had long thought answered, such as how to tame disruptive boom-and-bust cycles. ...

"We could be looking at a paradigm shift," says Frederic Mishkin, a former Federal Reserve governor now at Columbia University.

That shift could change the way central bankers do their job, possibly leading them to wade more deeply into markets. They could, for example, place greater emphasis on the amount of borrowing in the economy, rather than just the interest rates at which borrowing is done. In boom times, that could lead them to restrict how much money various players, ranging from hedge funds to home buyers, can borrow.

I tend to agree with the theory. The recent bubble demonstrates that the market isn't always right. But, the problem with the theory is that the market was largely driven by leverage and inappropriately rated securities.

There's no way to limit lending during good times when the good times are driven by an opaque derivatives market where collateral can't be accurately priced. (Certainly the "market" didn't price them correctly.).

Before anyone retorts that the bubble had other causes. I agree. Interest rates held too low for too long. Rising global wealth, leading to more money seeking returns. The Yen carry trade. Both Clinton and Bush using social engineering to promote an "ownership society."

But, the opaque derivative market was unbelievably huge. According to the U.S. Comptroller of the Currency (OCC), on June 30, 2008, U.S. commercial banks held $182.1 trillion in notional value (face value) derivatives. And, according to the Bank of International Settlements (BIS), which produced a tally six months earlier for the entire world, the global pile-up of derivatives, including institutions in the U.S., Europe and Asia, was more than three times larger — $596 trillion

That was ten times the gross domestic product of the entire planet.

According to the British Bankers Association, the CDS market (a subset of derivatives) expanded from just $180 billion in 1996 to a stunning $20 trillion in 2006. That’s a 111-fold expansion in this esoteric, opaque market. And by all accounts, it continued to into 2007 — to a whopping $57.9 TRILLION, according to the Bank for International Settlements.

What's really remarkable is that the chairperson of the Commodities and Futures Trading Commission (CFTC) warned of the risk associated with the over-the-counter derivatives market in 1996-97. She was *squashed* by Rubin, Summers and Greenspan.

A week before the LTCM crisis, Greenspan argued for less regulation on margin/leverage. LTCM was largely a problem with leverage. After the crisis was resolved, the CFTC chairperson was forced out.

Greenspan went on to receive the "Freedom" medal. Rubin went to Citibank (now receiving "bailout" money). Summers serves President Obama as a financial adviser.

Unbelievable perverse. Especially when you consider how Greenspan testified to Congress after the recent meltdown, saying his libertarian philosophy hadn't worked out like he thought it would.

A one-hour show about this can be watched online here: http://www.pbs.org/wgbh/pages/frontline/warning/

Just for the record, CNBC financial analysts are NOT economists. The term "economist" is too often used loosely is discussions bashing the profession. 100% of all those doing the bashing have 0% credibility without even a basic understanding in ECON 101 principles.

Anonymous said..."99% of all economists have proven that they are less than worthless idiots in the last decade. Anyone who did listen to them and drank their koolaid is probably broke or has been bailed out."

Tuskenrayder said..."Just for the record, CNBC financial analysts are NOT economists. The term "economist" is too often used loosely is discussions bashing the profession. 100% of all those doing the bashing have 0% credibility without even a basic understanding in ECON 101 principles."

While many people may confuse "economists" with "economic commentators", Anonymous is correct that most economists missed the threat of the growing housing and credit bubble. For example, the Federal Reserve missed it and the Fed is filled with economics Ph.D.s.

That said, I disagree with his assertion that economists are less than worthless idiots. Some economists like Dean Baker and Robert Shiller did notice the bubble, but they did so by ignoring mainstream economic thought. I studied macro through the intermediate level (the level taught to econ undergrads and some MBA students) and never came across a discussion of bubbles.

Let me make this simple. Study the UN Agenda 21 plan. It's all there. The masters of the pretend masters of the Universe have made the plan public. But you never heard of it and it's not on TV so it doesn't exist.